Today’s article comes from the mailbag. Recently someone wrote in with the following question:
Q: Are 401(k) contributions subject to FICA taxes? Are there any benefits or savings accounts which aren’t subject to FICA taxes?
It’s a perceptive question and illustrates that not all “pre-tax” contributions are created equal. Some are worth more than others.
FICA is the Federal Insurance Contributions Act but is better known as the Social Security and Medicare tax imposed on both employees and employers.
As an employee, you are responsible for paying a 6.2% Social Security tax on the first $127,200 of income up to a maximum tax payment of $7,886.40. With Medicare, the tax is 1.45% on the first $200,000 of income and then 2.35% on amounts above $200,000. The 2.35% is based on the 1.45% rate plus an Additional Medicare Tax of 0.9% imposed by the Affordable Care Act.
Employers pay the other half of the FICA taxes on your behalf, meaning they contribute 6.2% of your salary to Social Security and 1.45% to Medicare. If you’re self-employed (i.e. earning any kind of 1099 income) you have the obligation of paying the self-employment tax which is both the employee and employer portion of FICA taxes.
Now, some people would argue that Social Security isn’t a tax but is instead a forced savings mechanism since you pay into the program today and receive benefits at some date in the future (an article for a different post). But since benefits are based on contributions, it’s important to understand how your Social Security benefits are calculated.
Those future benefits are based on your highest earning 35 working years. If, during any of those years, you have income which is not subject to Social Security tax, that income won’t be counted in your Social Security income for that year. For example, if you look at Box 3 of your W-2 you will see your reported Social Security wages for the year. Box 3 is your Social Security income for the year and will never be higher than the maximum amount of Social Security that is taxable for that year.
Treatment of pre-tax 401(k) contributions
Since everyone refers to contributions to a traditional 401(k) as pre-tax, you’d be forgiven for thinking that you’re not paying any taxes on those amounts. However, that’s the case.
401(k) contributions are subject to FICA taxes.
This means you’ll see your 401(k) contributions reported in Box 3 (Social Security Wages) and Box 5 (Medicare Wages) of your W-2.
Of course, if you’re making more than $127,200 in 2017, the Social Security component isn’t relevant because you’re already paying the maximum amount of Social Security tax.
You will, however, be paying the Medicare portion of the FICA tax on those 401(k) contributions.
Because 401(k) contributions are subject to FICA taxes, you won’t be paying these taxes when you withdraw your 401(k) contributions in the future (however, you will of course pay income tax). And, the earnings from the 401(k) contributions are not earned income and so will also not be subject to future FICA taxes.
What’s not subject to FICA taxes?
There are a few benefits that aren’t subject to FICA taxes, meaning these pre-tax dollars are sheltered even further thank 401(k) contributions. The IRS counts these types of benefits as a reduction to your income (exempt wages) and therefore they never show up in Box 1, Box 3 or Box 5 of your W-2.
Perhaps the most familiar of these types of benefits are what’s known as 125 cafeteria plans, named after (you guessed it) Section 125 of the U.S. Code.
The cafeteria description comes from employees being able to pick and choose which benefits they want, such as health insurance, supplemental insurance (vision, dental, etc.), flexible spending accounts and qualified transportation benefits.
Again, your W-2 should be instrumental in helping you understand which benefits fall under Section 125. In 2016 I was able to include a little more than $5,000 of income in Section 125, which meant I didn’t have to pay Medicare tax on that amount which saved me about $120 bucks. Not exactly a lot of money, but we never say no to free money around here.
Mostly, this covered things like my health insurance premiums and transportation benefits (including paying for Uber rides pre-tax). If I had children and paid for child care, I could have excluded an additional $5,000 through a Dependent Care FSA (Editor Note: Following publication, I looked into this further and it appears as a Highly Compensated Employee I’m in fact not eligible for the Dependent Care FSA at my employer. Bummer.).
The other big component of my Section 125 cafeteria plan came from my contributions to a Heath Savings Account (also know as the Stealth IRA).
The rules around contributions to your Health Savings Account being exempt from Medicare and Social Security taxes are a little tricky, but employer contributions made to your Health Savings Account are exempt (See Question 19).
So what about employee contributions to a Health Savings Account? See this portion of IRS Publication 15:
Health savings accounts and medical savings accounts. Your contributions to an employee’s health savings account (HSA) or Archer medical savings account (MSA) aren’t subject to social security, Medicare, or FUTA taxes, or federal income tax withholding if it is reasonable to believe at the time of payment of the contributions they’ll be excludable from the income of the employee. To the extent it isn’t reasonable to believe they’ll be excludable, your contributions are subject to these taxes. Employee contributions to their HSAs or MSAs through a payroll deduction plan must be included in wages and are subject to social security, Medicare, and FUTA taxes and income tax withholding. However, HSA contributions made under a salary reduction arrangement in a section 125 cafeteria plan aren’t wages and aren’t subject to employment taxes or withholding. For more information, see the Instructions for Form 8889.
As long as your Health Savings Account contributions are made as a salary reduction arrangement, they’re considered employer contributions and therefore exempt from Social Security and Medicare tax.
This means that if you make HSA contributions directly through payroll, you likely won’t be paying FICA taxes on those contributions.
These contributions should show up as Code W in Box 12 of your W-2.
However, if you choose not to use your employer’s Health Savings Account provider and make contributions outside of payroll, those contributions would be deemed employee contributions and therefore subject to FICA.
This seems like a quirk in the law. Why wouldn’t all Health Savings contributions be free from FICA taxes, including those made by the self-employed (which count as “employee” contributions and are therefore subject to FICA taxes)? But I didn’t write the rules!
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.